Filling the Independence Black Hole

Posted by Craig Davidson58sc on November 07, 2016

Filling the independence black hole: cuts and job losses under the nationalists

- New research by Scotland in Union

Scotland would face a £10.4 billion shortfall in its public finances on independence, a combination of a higher deficit than the UK and other elements including government set up costs and higher interest costs.It would probably not be feasible to meet this shortfall from higher borrowing, given the likely cost of borrowing and debt servicing for a new country in Scotland’s situation. Instead, as a nationalist politician has pointed out, a period of ‘fiscal consolidation’ – a combination of tax increases and spending cuts – would be needed to reduce the deficit to UK levels.

This briefing paper uses the Scottish Government’s own model of the Scottish economy to estimate the impact on jobs and output from lower demand assuming half the £10.4bn was met through tax increases and half through spending cuts.Under this scenario Scottish Independence would result in 127,500 job losses and a 3% loss of economic output from the fiscal squeeze.It’s time for more honesty from the nationalist leadership about what fiscal plans they have for independence.

Scotland’s double deficit

As is now well known, an independent Scotland would face a fiscal deficit – the gap between revenues raised and public expenditure - much larger than the UK’s.This is because Scotland receives a ‘Union Dividend’ of higher public spending via the ‘Barnett Formula’ from our membership of the UK.

In addition, an independent Scotland would face various other costs.For example, the SNP has estimated the costs of setting up new government departments. If an independent Scotland joined the EU (a path which is currently unclear and an outcome which is uncertain), it would have to pay into the EU budget.Scotland would also no longer enjoy UK renewable energy subsidies.It would also face higher borrowing costs on government debt.These costs have been estimated by various government agencies and the total has been calculated by consultants Europe Economics to total £10.4bn in the first year of independence[1].

Filling the black hole - ‘Fiscal Consolidation’

How would this ‘black hole’ be filled?Even nationalist politicians have started to admit that post-independence economic life would be difficult for Scotland.SNP Westminster leader Angus Robertson has called for a ‘new honesty’ in nationalist economic predictions, while the SNP’s George Kerevan MP – a member of the House of Commons Treasury Select Committee – has predicted at least five years of ‘fiscal consolidation’ would be needed to bridge the gap.

The nationalists have not yet revealed what their plans would be in the event of independence – what the ‘fiscal consolidation’ would consist of.Instead we must look at realistic scenarios for how the £10.4 billion could be financed.As ever there are three fiscal options for governments: raising revenues through taxation, cutting spending, or increasing borrowing.

Limits on borrowing

In the short term, an independent Scottish Government could seek to increase government borrowing to meet some of the fiscal shortfall.However, in practice it would not be sustainable for an independent Scotland to finance this additional £10.4bn permanently through public borrowing.The deficit would be much greater than that of any advanced economy.A newly independent Scotland, attempting to set up a new currency and establish itself as a credible actor in international finance markets would not be able to borrow at these levels.

Even financing its share of existing UK debt would come at a higher cost than the UK pays[2].Taking on such a large amount of additional debt would cause serious problems for Scotland’s new currency and ability to finance itself.

If EU entry is part of the nationalists’ plans, then Scotland would have to meet the ‘convergence criteria’ for the Euro and would also be subject to the EU’s Stability and Growth Pact, which limits deficits to 3%GDP in normal times.The EU is already raising sanctions against Portugal and Spain for failing to make ‘reasonable progress’ to reduce their deficits.

Instead, we must assume that an independent Scotland would have to fill the gap over a relatively short period by reducing public spending and / or increasing taxes, remembering that even paying off the £10.4 billion would still leave Scotland’s deficit at the same level as the UK’s average (3% of GDP).

Cuts or new taxes?

Some nationalists predict that an independent Scotland would enjoy higher economic growth than it does at the moment, and that this would generate higher revenues.There is no evidence for this.Since the SNP first took power, growth in Scotland has been consistently lower than in the UK.The devolution of major economic powers to a Holyrood run by nationalists since 2007 has made no difference to this[3]. The SNP’s record on economic management is worse than the UK government’s, not better.

Besides, growth would need to be much higher than it is now for decades to come to close the fiscal deficit[4].It is not practical to rely on higher growth to fill the hole in the timescale required.In the end, the deficit would have to be closed either by raising taxes or cutting public spending or a combination of the two.

Taxed until the pips squeak?

An independent Scottish Government could seek to fill the £10.4bn gap by raising taxes.Public revenue in Scotland totalled £53.7bn in 2015/16, including a geographical share of North Sea oil and gas revenues.To fill the gap by raising taxes alone would require tax revenue to increase by 19.4% overnight.Former Prime Minister and Chancellor Gordon Brown has suggested that income tax would have to be doubled in an independent Scotland to close the deficit[5].

The economist John McLaren suggested that part of the deficit could be met by rises in income tax, VAT and a tax on the whisky industry, contributing a net £3.5bn[6], alongside cuts to public spending and increased borrowing.

However it would most likely not be feasible to raise the full £10.4 billion from tax increases.While it is possible to estimate short term revenue increases from tax rises proportionate to their existing yield, excessive tax increases would suffer from the law of diminishing returns as economic activity was damaged.Apart from reducing incentives and private sector activity generally, investment and skilled labour would be diverted away from Scotland to lower tax jurisdictions[7].

A combination of short term borrowing, taxes and cuts

Neither excessive borrowing nor tax increases can fill the fiscal gap created by an independent Scotland.Some cuts to public spending would be presumably inevitable, therefore.

Assuming that borrowing would need to be reduced to UK levels over a relatively short period of time (George Kerevan’s five-year timescale at best), Scotland would need to find £10.4bn of tax increases and spending cuts over that period.

Given the practical limits to tax increases, a reasonable starting point would be to assume the target was achieved half by tax increases and half by spending cuts.Reducing expenditure by £5.2bn would still leave public spending higher than in the rest of the UK (by £200 per head on average[8]).

What impact would such cuts and tax increases have on the Scottish economy and Scottish jobs?

The Scottish Government economic model

The Scottish Government produces a detailed economic model of the Scottish economy that sets out the various links between different sectors of the economy and how demand from each sector affects the others[9].It allows us to estimate the impact on the economy of changes in overall demand, including reductions in government spending, the impact of new taxes and so on.

The model is used by the Scottish Government and others to assess what would happen under various different scenarios, and is published and designed for public use as well.

Preferably, the nationalist leadership will make public how it plans to pay for the additional £10.4bn deficit in the event of independence – which taxes it would increase, what cuts it would impose, how much extra borrowing it felt it could take on in the short term and so on.

In the absence of this information it is reasonable for us to make our own estimates and to use the Scottish Government economic model under this scenario.

The impact on jobs and output

Scotland in Union has used the Scottish Government’s economic model to estimate the impact of independence on jobs and economic output.The model calculates the effect of changes in household and public expenditure, and how this would affect demand throughout the economy.This allows us to estimate the total impacts of a scenario where the £10.4bn is met half by tax increases (on households via taxes such as income tax and VAT) and half by public spending cuts (spread across the board).The impacts take place during the period of ‘fiscal consolidation’.They do not include ongoing economic effects from independence such as the impact of new barriers to trade with the rest of the UK, lower investment and so on[10].

According to the Scottish Government’s economic model, this would result in 127,500 jobs lost in the first year of independence (5% of Scotland’s workforce), most notably in the public sector, but with spillages also into private businesses that rely on demand from public services and households.Economic output would fall by 3%:The scale of job losses would be enough to eliminate all employment gains made from 2008 since the last economic downturn.

The following table shows the sectors with the greatest jobs losses, according to the Scottish Government’s model:

Health

30,000

Education

20,000

Public administration

16,000

Social work

12,000

Retail

11,000

Conclusion: a plea for openness

The Scottish Government’s own economic modelling shows a severe impact on Scotland from the fiscal consolidation that would be required on independence, with tens of thousands of jobs lost and a serious fall in economic output.This would be on top of longer terms damage caused by the disruption to trade with the rest of the UK, the impact of a new currency, lower investment and so on.

The nationalist leadership needs to be more open with the Scottish public and explain their fiscal and economic plans for independence in more detail, and particular which cuts and tax rises they envisage and how much more money they plan to borrow and at what cost.

Until they do so it is sensible for concerned members of the public to estimate the impact of nationalist plans using the best evidence and methodology available.Doing so reveals a very worrying vision of the future which casts serious doubt on the credibility of those advocating independence.

[1] What Costs Would an Independent Scotland Bear in its first year? Europe Economics March 2016

[3] Since the 2008 recession, Scottish GDP has risen by only 4%, compared to 23% for the UK as a whole (Scottish Trends, May 2016).

[4] The Scottish Government’s white paper on independence suggested that if Scotland matched the growth rate of other small European countries it might close a quarter of Scotland’s additional fiscal deficit in thirty years (see analysis by Kevin Hague 13/5/2015).

[5] Speaking at the 2016 Edinburgh International Book Festival. Income tax currently raises £12.2 billion in Scotland.

[10] The Fraser of Allander Institute estimated the ongoing economic impacts from disruptions to trade and investment of Brexit (The Long Term Economic Implications of Brexit, October 2016) at between 2% and 5% over ten years. Since Scotland trades 3-4 times as much with the rest of the UK as it does with the rest of the EU, these long term impacts would be multiplied in the event of independence.